Will you run out of money in retirement? Part II

By Kurt Brouwer

Obviously, we cannot know the future, so we are considering probabilities when we seek answers to this question. By doing this analysis though, I believe you may gain the comfort that you are probably in good shape. Or, you might gain the knowledge that you have some work ahead of you. In either case, this process is worth doing. At the end of Part I, I mentioned three critical factors you need to evaluate in order to come up with a coherent answer to the question, Will you run out of money in retirement?

I. Spending: Let’s say you are on the cusp of retiring. First, congratulations are in order. You made it. To start, you need to figure out how much you spend now. I know that sounds obvious, but many people don’t really know what they are spending.

We use a Microsoft Excel worksheet to help people go through this exercise so they don’t miss any major spending categories. If you’d like a copy of that, just send me an email and we’ll send it to you.

One of the biggest areas of confusion about spending is your home. People spend a lot of money on upkeep and maintenance, insurance, property taxes, principal and interest payments and home improvements. It’s easy to miss something.

Other easy items to miss are expenses that come once a year (such as many types of insurance) or expenses that occur irregularly, such as replacing a car or a furnace or a roof. Once you have a good handle on how much your spend now, you can estimate what you will spend in retirement. In order to look forward in terms of spending, you have to make some decisions.

Decisions…decisions

Your home: Are you planning to stay where you are? If so, home expenses may not change much, until you pay off your mortgage. If you plan to downsize your home, will you buy a condo or rent. For many retirees, renting is hard to imagine as they have owned a home for decades, but renting makes far more economic sense for most older people once they make the decisions to downsize.

Your state or city? If you are planning to move, are you considering another state or even another country? If so, the cost of living in that place is important as are all the various taxes (income tax, sales tax, property tax). There are places around the country — and around the world — where your money may go a lot further than it does where you live now. Or, you may be considering a move to be close to family or even to bring about a lifestyle change. A change such as this complicates things, but that’s OK.

There are rules of thumb for adjusting your working level of income to see how much you will need in retirement, but I have not found them terribly useful. I think it’s much better to track your current spending and then go through and make adjustments to deal with your contemplated lifestyle changes during retirement.

For example, if you decide to downsize, you would estimate your retirement housing costs in terms of a rental or a smaller home compared to what you now have. Also, you may have a fair amount of work-related expenses in your budget. On the other side of the equation, you may be planning lots of travel once you retire, so your travel budget would need to be boosted.

One way to make a realistic estimate of post-retirement expenses is to talk with those who are already retired. This should not be a huge revelation, but I have found that many folks are reluctant to ask family members or friends or others about what life in retirement is like or to find out how their spending compares to spending before they retired. Most retired folks that I know are happy to help others and share their knowledge. So, if you have questions, just ask.

II. Steady Income: Steady income includes all sources of income that will continue throughout your retirement. Figuring this out is generally the most straightforward part of the process.

Social Security: Most people will have Social Security income during retirement and the Social Security administration sends out a specific statement for your personal Social Security benefit at retirement. The only big decision for Social Security is whether or not to take it immediately or to wait until full retirement age. This chart from the Social Security administration illustrates how your initial monthly benefit can change depending on your age when you start taking Social Security.

As you can see, assuming a retiree has a full benefit of $1,000 per month at age 66, the actual benefit could be higher or lower depending on what age the retiree actually elects to start taking the benefit. Many articles I have seen recommend waiting until age 66 to get the full benefit. That may not necessarily be the best choice for many people because you have to give up four years of Social Security benefits to get the higher amount. The reason it may not make sense for you to wait until full retirement age is that the crossover point could be about 12 years. That is, it takes 12 years at the higher benefit amount to make up the amount you missed by not taking benefits at 62.

For example, using the numbers in the chart above, at age 62, you would get $750 per month for four years for a total of $36,000. On the other hand, if you wait until age 66 for full benefits, you would get an extra $3,000 per year ($250 per month). Without getting too fancy, in actual dollars it would take about 12 years to make up the money you missed by waiting.

If you plan to work until 66, it probably makes sense to wait to take benefits until that age. However, many people may want to take benefits at 62 just to bring in some income. That method will give you more money until the crossover point is reached in about 12 years.

Many folks will have some part-time or full-time employment income during the early years of retirement and that could impact your decision on when to take Social Security benefits among other things. For more on this issue, you can go to the Social Security Administration’s Retirement Benefit site.

Other pension benefits: If you are lucky enough to have an outside pension plan from your employer, then that is an additional source of income during retirement. In addition to the pension income, you may also be eligible for additional benefits such as retiree health insurance. One very important question to consider with an outside pension is whether to take the monthly income option or to take a lump sum distribution, assuming that option is available to you. If you are at all concerned about the level of funding for your pension, taking a lump sum may make sense.

III. Savings & Investments

This category includes all your savings and investment accounts, including IRAs, 401(k)s, personal savings and investments. Looking at your assets means you would also potentially include other assets such as your home or a business or anything else you have that is valuable. You may want to remain in your home now, but it is still a resource if you have some equity in it.

If there is a gap between your spending (Section I) and your steady outside income (Section II), then your portfolio has to be tapped to make up the difference. In Part III, we will cover historical investment returns, reasonable spending assumptions and more.

About Fundmastery Blog

Kurt Brouwer is a fee-only financial advisor with three decades of experience. He is the chairman and co-founder of Brouwer & Janachowski, LLC. Kurt has written books, articles and hundreds of blog posts on mutual funds, ETFs and other investment topics. E-mail: kurt.brouwer *at* gmail.com.